When is Sentiment Analysis Good and When is Bad?

The foreign exchange market is made up of a large number of participants, including investment banks, multinational companies, hedge funds, etc. However, behind big business and powerful financial institutions are people with emotions, fears and expectations.

The people who make up the forex market are not robots. That means they wait for prices to move in a certain way and express their feelings in different ways. This is the idea behind the Forex market sentiment.

Do markets have “feelings”?

Although it may seem a little incredible, the financial markets, including the Forex market, take one direction or the other.

They can be either bearish or bullish, not just because of the effects of the fundamentals or because of what technical analysis sometimes tells us.

Markets do not always follow a linear behaviour, according to expected parameters. As Aristotle said, “reality is not always as it is presented to us”. This is due to the feelings of the market and that is where the analysis of feelings appears.

Markets can be euphoric or fearful of certain events. They may even take a certain direction, at first, and then adopt the opposite direction.

In August 2017, growing tension between the United States and North Korea caused fear among investors who quickly sought refuge assets.

This market sentiment, the one of fear, ended up causing a bearish trend for the U.S. currency. Here, sentiment analysis was expressed with a certain behavior of investors.

The emergence of “financial bubbles” is often the result of investors’ actions, driven essentially by market sentiment and not by specific issues.

Is Sentiment Analysis important?

If we traders put on the table the technical analysis and the fundamental analysis to know what position we should take against a currency pair, we would surely get very accurate data that will guide us in a certain direction and tell us whether to bet short or long.

But then, we see that the currency market is not behaving as we had speculated. This is where sentiment analysis becomes important.

It is the way in which we will get to know why the market has behaved or is behaving in a different way than expected.

Sentiment analysis is a tool that we should not neglect. Let’s remember that our position in the Forex market will never be strong enough to turn the tide on it.

The higher the proportion of people adopting a position, the stronger the market sentiment and the more likely the movement predicted by traders is to occur.

For example, if the EUR/USD market sentiment shows that 80% of traders believe the pair will rise in value, it is much more likely to do so. Therefore, in such a situation, it would be prudent to assume a long position.

However, this is not the only way market sentiment is used.

For instance, there is a group of operators who choose to do the complete opposite: adopt the opposite position to the one indicated by the majority. The logic behind this method is that if there are many beginners and inexperienced people in the market sentiment sample, they are more likely to be wrong.

Similarly, there are indicators of Forex sentiment that are based on the opinions of traders, rather than mathematical or statistical formulas (such as technical analysis).

Forex Market Sentiment Indicators

Forex market sentiment is not only limited to the accounting of long vs. short trades in a given community. There are sentiment indicators that serve to show in a rational way the reactions of market participants to events that can create currency price movements.

There are several indicators of market sentiment, although the most important are:

AAII Investors Sentiment Survey

Commitment of Traders (COT)

Volatility Index (VIX)

eFXto Market Sentiment

As you can see, Forex sentiment plays a very important role in financial trading, including currency trading.

The general mood of the market gives signals of price directions. Follow the thinking of traders, either bullish or bearish. Market sentiment evaluates the psychological and emotional attitude of all market participants.

You can apply this type of analysis to predict price movements based on the present (in this aspect it differs from technical and fundamental analysis). Also, to make your analysis more accurate, you must ultimately use sentimental indicators.

These kinds of tools can help you understand the reasons behind market movements. Keep in mind that extreme numbers are signs that prices are about to change direction.